APRA outlines remuneration changes

While the depth and breadth of the remuneration proposals released by APRA on 23 July 20191 is hardly surprising given the Hayne Royal Commission findings and APRA's own 2018 report on the issue, there are a few points in them that warrant particularly close attention.

 

Scope of the Remuneration Framework

Unlike the limited scope of the remuneration provisions of Prudential Standard CPS 510 Governance, the draft new Prudential Standard CPS 511 Remuneration sets out regulation for an entire remuneration framework. It will require regulated entities to have a Remuneration Policy and associated procedures, systems and processes which cover all of the entity's remuneration objectives and arrangements.

That, in itself, will require a whole new level of rigour to be employed. Of particular note, however, is the proposal that the framework should extend beyond the entity's own employees to the remuneration arrangements of two other categories of people.

First, is the requirement that it cover employees of related bodies corporate. While this will make sense in many cases, it could presumably also involve entities which carry on quite separate businesses. That point might need some clarification.

Secondly, APRA is proposing that the remuneration framework also extend to the remuneration arrangements of employees of certain service providers to the entity. These include the providers of risk, compliance, internal audit and financial and actuarial control services; which will involve delving into the remuneration arrangements of such professional advisors. More significantly, though, they will also include the providers of services which "may affect the entity's long-term soundness or materially affect the management of financial or non-financial risks", where a material amount of the payment for the services is based on performance. Some regulated entities will have a range of service providers which fall within this category. Consider, for instance, an insurance intermediary with direct responsibility for customer interactions. The intermediary is paid principally by commission and so is paid for performance. Provided the materiality threshold is met, the insurer concerned would need to apply its remuneration framework to the intermediary's own employees. How that would be done in practice would need some careful consideration.

Non-financial measures in variable remuneration

APRA is not proposing to cap variable remuneration, either in dollar terms or as a proportion of total remuneration.  However, it is proposing to limit the extent to which financial performance measures can be used for variable remuneration – specifically that those measures make up no more than 50% of the weighting for variable remuneration overall, and that individual financial performance comprise no more than 25% of the measures used.

Having a greater proportion of remuneration based on non-financial measures will undoubtedly present some challenges. APRA recognises the need for those measures to be objectively based. But what will they look like?

Non-financial measures might relate to compliance breaches, poor customer or risk outcomes and misconduct. They could also include more operational measures, such as operational control effectiveness, reputation issues, employee engagement or alignment with certain aspects of the entity's strategy or values. Some of these will be easier to track and measure than others. Accountability for outcomes should become clearer as BEAR is progressively implemented, however, it will inevitably be difficult to avoid any element of qualitative assessment in these non-financial measurements.

Significant Financial Institutions

APRA is proposing to apply additional deferral and clawback requirements to variable remuneration for "significant financial institutions" (SFIs). According to the definition in the Prudential Standard, an SFI is a "large, complex entity as determined by APRA". In its Discussion Paper, APRA proposes the use of an asset test for ADIs and insurers ($15B and $10B respectively) and a funds under management test for superannuation entities ($30B). In the general insurance world, by way of example, this could be expected to capture IAG, Suncorp, QBE and Allianz.

The additional SFI obligations will be material for their senior managers. In short, a set proportion of all variable remuneration will not vest for 4 years (60% for CEOs and 40% for other senior managers). After that period has passed, the deferred component will vest on a pro-rata basis over the following 3 years (CEO) and 2 years (other senior managers). There would then follow a clawback period which could extend for as long as a further 4 years.

To put that in real terms, if the CEO of an SFI was entitled to $500K in variable remuneration, $200K of that could vest immediately. The remaining $300K would only begin to vest after 4 years, at the rate of $100K per annum.  All of this variable remuneration could also be subject to clawback after payment. This would mean that the CEO's variable remuneration payment may not become absolute for 11 years.

The clawback provisions would also include the interesting requirement that variable remuneration should only be awarded "if an amount corresponding to it can be recovered from the person" where the clawback requirements justify it. This seems to anticipate that some form of security would need to be provided for the payment, for instance in the form of a set-off against future remuneration payments or, for departing employees, some other form.

All of this makes the proposal to designate an entity as an SFI a material one.

Board responsibilities

Consistent with what we're seeing in other spheres, APRA is expanding upon the Board's responsibilities for the remuneration framework.

In addition to approving the entity's Remuneration Policy, the Board will be required to "actively oversee" the framework, including with respect to its design, operation and monitoring.

APRA anticipates that, in order to meet this requirement, the Board will need to be provided with "comprehensive reporting" of remuneration arrangements and outcomes (an obligation which it places on the Board to obtain). That will undoubtedly be the case.

APRA is also proposing that entities carry out an annual review of compliance with the framework and arrange for an independent review of effectiveness to be carried out every three years (ie. similar to that required for the risk management framework under Prudential Standard CPS 220 Risk Management). Boards will be expected to receive and oversee responses to these reviews. In APRA's words, they are to "take appropriate and timely action to ensure the findings … are adequately addressed and implemented".

Boards will also be expected to take a more detailed approach to approving remuneration outcomes. In particular, APRA is proposing that the Board must individually assess and approve remuneration arrangements and variable remuneration outcomes for all senior managers and "highly paid material risk-takers" (a new category of person whose "activities have a material potential impact on the entity's risk profile" and who have a total remuneration package of $1 million or greater). Given the expectation that there should be an active approach to risk adjustments over a lengthy deferral period, Boards will need to be well briefed in order to carry out this obligation, particularly where adjustments are to be made based on non-financial measures.

Publication

Finally, APRA has invited feedback on a proposal that regulated entities publish their Remuneration Policy and the specific performance metrics they are using to set variable remuneration for senior managers. While little is said about the depth of information to be published, APRA appears to envisage that it would be sufficient to show whether individual senior managers had met their performance hurdles.

This part of APRA's proposals has not been set out in the draft Prudential Standard, presumably recognising that it will raise some concerns. Currently, the structure of senior managers' variable remuneration is not publicised internally, let alone to the public.

What  timing has APRA proposed?

Although APRA has proposed a 1 July 2021 start date for the changes, it has stated that it is expecting regulated entities to move towards the requirements before then. The key steps along the path to that date are:

  • Submissions will be taken on the proposal until 23 October 2019
  • APRA plans to finalise the new CPS 511 in late 2019 or early 2020
  • APRA will consult on a Prudential Practice Guide during 2020
The link to APRA's proposals can be found at:
https://www.apra.gov.au/consultation-remuneration-requirements-all-apra-regulated-entities

For more information on the remuneration proposals or any aspect of this article, please contact insurance advisory principal, Mathew Kaley. Please also see our previous article, Remuneration and how it drives your culture – takeaways for all organisations from the Royal Commission by employment principal, Nicola Martin.


1 Discussion Paper, "Strengthening prudential requirements for remuneration" dated 23 July 2019